Thursday, January 12, 2012

The Chinese Economy: A Drag on Australia in 2012?

One of the most interesting commentators on the Chinese (and global) economy is Michael Pettis. A consistent theme of his newsletter (which you can receive by asking him to send it to you!) is that many economic commentators don’t understand or at least downplay the significance of global imbalances and the concept of the balance of payments.

I’ve long argued to my students in the course Power in East Asia that Chinese purchases of US bonds are not a straight forward indicator of growing Chinese power (indeed I might have been a little more forceful than that). The belief that the Chinese could simply stop purchasing US bonds would require them to change their growth model and is not likely to happen anytime soon. But even if they did, it would not be the disaster for the US economy that many commentators seem to think.

Pettis writes:
One of the more absurd fears that still pops up every few months is the panic over the possibility that foreign central banks (i.e. the Chinese) might stop “lending” to the US government. If they ever decide to stop buying US Treasury bonds, the argument goes, US interest rates would soar and the US government would suddenly find itself unable to fund its fiscal deficit

Chinese “lending” to the US government is not a discretionary decision that they can choose or not choose to do – it is the automatic consequence of a growth model that requires a trade surplus to absorb domestic overcapacity – the idea that the US government needs foreign funding is based on a very fundamental misunderstanding of the balance of payments. The US government does not need foreign buyers for its bonds. On the contrary, it is in Washington’s best interest that foreign central banks sharply reduce their purchases of USG bonds.
He then explains why recent reduced purchases of US bonds have not led to an increase in interest rates.

US interest rates have very little to do with foreign purchases of US government bonds.

Why? Because foreigners do not fund fiscal deficits. They fund current account deficits, and as an accounting requirement the size of the current account deficit is exactly equal to the net foreign funding.  Capital account inflows must exactly match current account outflows.

The direction of causality can go either way. If investment in the US is so high, for example, that it is impossible for US savings to supply the full demand (as occurred during much of the 19th Century), then the US must import foreign capital to make up the shortfall. The difference between domestic US investment and domestic US savings, of course, is equal to the net amount of foreign savings imported into the US, and is also equal to the US current account deficit. In this case soaring US investment causes the US to have a current account deficit and leads foreigners to fund this excess investment.
But as he then points out the direction of causality is not clear cut. While the CAD is equal to saving minus investment, rising ‘investment’ might be spurred by capital inflows, rather than the other way round.

But the direction of causality can also run the opposite way. Suppose foreign central banks have decided for domestic reasons (for example in order to generate domestic employment) to accumulate hoards of US government obligations and so run a trade surplus. This will cause a surge of net capital inflow into the US. In that case the US must run a current account deficit equal to the net inflow. 

There are several ways this can happen. One way is for the surge in foreign capital inflows to cause a sharp rise in what otherwise would have been unnecessary or unfunded investment – the real estate bubbles in Spain and the US might be obvious examples of this. Another way is for foreign savings to displace domestic savings, perhaps by funding a credit-fuelled consumption boom. 
But Pettis argues that in some ways this beside the point, what many commentators miss is the simple maths involved. Net capital imports equal a current account deficit. The real issue for the US and China at the moment is what happens if foreigners, particularly the Chinese stop buying bonds. Rather than cause interest rates to rise and a collapse of the economy, the result is actually beneficial for growth. This is because:
if there is a reduction in net foreign capital inflows there must also be a reduction in the US current account deficit. 
The results are not necessarily benign.

In Spain, for example, it will happen as a collapse in domestic demand and high levels of unemployment.

For the US, however, the result is likely to be better because reduced capital inflows will further reduce the value of the dollar leading to an increase in exports and therefore a rise in employment.

US interest rates on the other hand are likely to remain unaffected

First, the decline in US unemployment will result in a decline in fiscal expenditures since the main reason for fiscal expansion is to reduce unemployment. Second the reduction in unemployment and the increase in business profits will increase tax revenues. Lower spending and higher revenues means less borrowing, and so fewer foreign purchases of US government bonds will be matched by fewer US government sales of bonds.
Remember that saying that the US needs more foreigners to buy US government bonds in order to keep interest rates low is exactly the same as saying the US needs a bigger current account deficit in order to keep interest rates low.This cannot be true.

So the question of whether the China buys US bonds or not is more dependent on the Chinese growth model of running current account surpluses.
… this is hard to predict since it is based more on political factors than economic ones.  China’s current account surplus has contracted quite dramatically in the past four years, not because of domestic rebalancing, of course, but because of forced foreign rebalancing, and there are many who think the trade balance may actually go into deficit next year. 
Pettis thinks it is unlikely that China will slow export growth anytime soon because of the view that this would be a disaster.

Huo Jianguo, head of the Ministry of Commerce's research unit, was much more explicit. Last week he warned about the consequences of slow export growth.

China needs annual export growth of at least 15 per cent to ensure stable economic expansion as the rate of domestic investment cools, the head of the trade ministry's think-tank said in comments published yesterday. "We just can't tolerate the simultaneous fall in investment, consumption and exports," Huo Jianguo, head of the Ministry of Commerce's research unit, told the Shanghai Securities News. "A growth rate of 15 per cent [in exports] is basically a benchmark and any growth below that would start to affect employment."

Beijing has pledged to stabilise exports and boost imports next year to balance trade as part of efforts to bring equilibrium back to the economy and insulate it from the effects of deteriorating external demand.  Many international economists believe China's growth has been fuelled by a reliance on investment spending, creating asset bubbles and overcapacity problems that pose more serious structural challenges than shifting external trade conditions. But Huo said concerns about falling exports were growing.

"In fact, the investment-driven model of 2009 has changed, exports are playing an incremental role in overall growth - so when export growth eases, people get nervous." Huo noted that at least 80 million jobs are related to exports - many of them held by migrant workers and therefore vital for social stability.
This is likely to lead to an increase in trade tensions. Remember the basics of global trade: not everyone can run a trade surplus. If the US and countries like Spain in Europe want to run a surplus or reduce their deficits, this will mean that China, Japan and Germany etc will have to reduce their surpluses.

Chinese and German trade surpluses must be matched by deficits elsewhere. Chinese and German export success must be matched by a willingness of other countries to buy their products. Now in an ideal world, a country’s trade surpluses would lead to increases in the value of its currency. In Europe this can’t work for individual members of the Eurozone and between the US and Asia equilibrating mechanisms are restricted both by Asian currency policies and perceptions of the US as a safe haven for capital.

Pettis then turns to the growing costs of debt service in China caused largely by excessive infrastructure investment. Growing debt is a real problem for China.

As we saw in the last debt crisis, a decade ago, debt-servicing costs are only manageable in China thanks to financial repression – i.e. extremely low lending rates funded by even lower deposit rates -- which implies a huge transfer, equal to several percentage points of GDP annually, from household savers to corporate and government borrowers. Households, in other words, typically clean up banking messes.

The problem with this solution is in what it implies about future growth in demand. If investment is being wasted, it must be reduced or it will create a debt crisis eventually. If the external environment is tough, the demand impact of a sharp drop in investment cannot be made up for by a surge in the trade surplus – in fact the trade surplus may actually contribute negative demand. So where will the demand come from needed to pull the Chinese economy? The only possibility is a surge in domestic consumption.
The solution of increasing consumption in China is often seen as a relatively simple phenomenon that will occur over time, almost as a matter of course. But recent years have seen decreases not increases in consumption. (although see here for an alternative view)

Indeed, one of the growing narratives by the Gillard government and particularly Treasurer Wayne Swan is the opportunities created by China that go beyond the mining boom. Swan argues that the growth of the Chinese middle class will create an export bonanza for Australia.

Of course, the mining boom is only one part of a much bigger and evolving story about the influence of China's rise on the world. The China story is not just a mining story; it's also a story of its dynamism and the spectacular growth we're seeing of its middle class. China's rapid growth is delivering hundreds of millions of people into a burgeoning middle class.

It's important here to distinguish between the complex and subtle process of ‘middle classing' and the simple process of ‘urbanising'. Some of China's many millions of internal migrants have achieved lifestyles that qualify as middle class, but the vast majority have not, at least not yet. It is the present and prospective shift of China's current working class and working poor into empowered consumers that will mean so much to Australia.
This, according to Pettis, might be a longer-term project than Swan seems to think.
Can consumption possibly surge? No, not if the household sector is going to be forced to clean up the banking mess again. This is the same problem that caused household consumption to drop after the last banking crisis from a very low 46% of GDP in 2000 to an astonishing 34% in 2010. 
Policies aimed at boosting consumption by offering incentives to purchases household goods and cars will no doubt increase spending on these items but …

since those subsidies were ultimately paid for by the household sector, the policies did not translate into an overall surge in consumption because there was no net increase in household wealth. In fact during both of those years consumption continued to decline sharply as a share of GDP.
The problem for China is not excessive saving, given that they save at about the same rate as other Asian countries. Instead the real problem is that household income is such a low share of GDP.

This means that the only way to boost consumption is redistribution from rich to poor or from the state to households.

When we add in the possibility of a continued decline in house prices throughout China, we may start to feel some kind of wealth effect dragging consumption growth down even further as a share of GDP, although I am not sure I am too worried about that. The housing boom seems to have mainly benefitted speculators, and I don’t think that it translated into a significant increase in consumption when housing pieces were on their way up. In that case it shouldn’t matter too much on the way down either, although it is better to wait and see what happens.
In the case of houses, prices are definitely falling in China, according to Pettis.

So it is debt that is the big problem, but past options used to 'solve' earlier debt problems are probably not available again.

This time however I really doubt that the debt crisis can again be resolved by financial repression, since household wealth is already far too small a share of GDP, and expected GDP growth prospects much lower than in the past. Remember that if GDP growth slows sharply, the only way households can continue permitting that their share of GDP declines, as it has for the last thirty years, is if household income growth drops to zero or even goes negative.

Slower growth and an already-low share of GDP will mean that it will be politically very difficult to force households to clean up the mess another time. Add to this the problem of illiquidity in the banking sector, which is going the become an increasing problem over the next few years as borrowers have trouble repaying loans and will require more-or-less permanent ever-greening, and I think there will be much greater appetite for a real liquidation of bad debt.
Australia is vulnerable to these potential problems in China and Australians are increasingly dependent on the Chinese Communist Party managing a rapidly growing, but increasingly unbalanced economy! But lots of people have thought that the Chinese growth model was unsustainable before, so I wouldn't take too large a bet on it collapsing.

Although given the reasonably high percentage of equity (shares) in my super accumulation fund I am in a way betting on Chinese growth continuing for a little while at least. Over the longer-term it is likely that China will continue to demand resources from Australia. It's the medium-term - the next 2-4 years that worries me.  

If you wanted to short the Chinese economy - that is a take abet against continuing high levels of growth in China -  then shorting Australian resource stocks would be a good strategy.

For what it's worth I think the Chinese authorities are likely to be able to cover up problems for a little while yet. Next year, however, is another betting opportunity.

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